Factors Affecting Capital Structure Decisions

Written by le bach pham
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Factors Affecting Capital Structure Decisions
Market conditions play an important role in capital structure decisions. (Thomas Northcut/Photodisc/Getty Images)

A company's capital structure is the method a company uses to finance its operations and growth utilising various sources of funding. Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. Firms that rely heavily on debt for financing operations pose greater investment risks. Factors that affect a company's capital structure include business risk, taxation, financial flexibility, management style, growth rate and market conditions.

Business Risk

Business risk is the basic risk of a firm's operations without factoring in debt. Greater business risk should be countered by a lower debt ratio in a firm's capital structure. For example, a fine art gallery has more risk than a utility company. A fine art business is subject to changing trends and economic conditions, which make the potential of losing higher. Therefore, it is advisable for businesses in the fine art industry to have a lower debt ratio. The utility company, on the other hand, has a more stable revenue stream.

Tax Exposure

Applicable tax laws and regulations may also play an important role in capital structure decisions. Since debt payments are tax deductible, if a company's tax rate is high, it may make sense to use debt as a means of financing. The tax deductibility of debt payments will protect some income from taxation.

Financial Flexibility

The lower a firm's debt ratio, the more flexibility the company has during difficult economic periods. Financial flexibility is a company's ability to raise capital during slow-growth periods. The airline industry is known to have poor financial flexibility in a stagnant economy.

Management Style

Preference in management style may affect what type of capital structure business owners choose. Conservative managers are less likely to use debt to raise funds. On the other hand, aggressive management styles attempt to create rapid growth, which may require larger amounts of debt.

Growth Stage

A business firm's capital structure may also depend upon the enterprise's current growth stage. Companies in the initial growth stages may tend to take on more debt in order to facilitate growth. However, many times firms may grow too rapidly, which causes their growth to be unstable. Firms that are more stable usually require less debt, due to more stable revenue streams.

Market Conditions

Market conditions are a significant factor in making capital structure decisions. In a stagnant market, investors may be less likely to invest capital; therefore, interest rates may be significantly higher. Therefore, companies may tend to avoid a high debt ratio during a struggling market.

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